Measuring and Evaluating

the Performance of Banks

and Their Principal
Competitors
McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2

Key Topics
Stock Values and Profitability Ratios
Measuring Credit, Liquidity, and Other
Risks
Measuring Operating Efficiency
Performance of Competing Financial Firms
Size and Location Effects
The UBPR and Comparing Performance
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2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-3

Value of the Banks Stock

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6-4

Value of a Banks Stock Rises When:

Expected Dividends Increase

Risk of the Bank Falls
Market Interest Rates Decrease
Combination of Expected Dividend
Increase and Risk Decline

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-5

Value of Banks Stock if Earnings

Growth is Constant

D1
P0
r-g
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6-6

Key Profitability Ratios in Banking

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital

Net Income
Return on Assets (ROA) =
Total Assets
(Interest income
- Interest expense) Net Interest Income
Net Interest Margin

Total Assets
Total Assets

Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
NetMcGraw-Hill/Irwin
Noninterest Margin

2008
The
McGraw-Hill
Companies,
Inc.,
Total
Assets
Total Assets
Bank Management and Financial Services,
7/e All
Rights Reserved.

6-7

Key Profitability Ratios in Banking

(cont.)
Total Operating Revenues Total Operating Expenses
Net Bank Operating Margin
Total Assets
Net Income After Taxes
Earnings Per Share (EPS)
Common Equity Shares Outstanding
Total Interest Income
Earnings Spread = Total Earning Assets

__ Total Interest Expense

Total Interest Bearing Liability

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-8

Breaking Down ROE

R O E = N e t In c o m e / T o ta l E q u ity C a p ita l
ROA =
N e t In c o m e /T o ta l A s s e ts

E q u ity M u ltip lie r =

T o ta l A s s e ts /E q u ity C a p ita l

N e t P ro fit M a rg in =
A s s e t U tiliz a tio n =
x
N e t In c o m e /T o ta l O p e ra tin g R e v e n u e T o ta l O p e ra tin g R e v e n u e /T o ta l A s s e ts
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Bank Management and Financial Services, 7/e All Rights Reserved.

6-9

ROE Depends On:

Equity Multiplier=Total assets/Total equity capital
Leverage or Financing Policies: the choice of
sources of funds (debt or equity)
Net Profit Margin=Net income/Total operating
revenue
Effectiveness of Expense Management (cost
control)
Asset Utilization=Total operating revenue/Total
assets
Portfolio Management Policies (the mix and yield
on assets)
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2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-10

Determinants of
ROE in a
Financial Firm

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6-11

Components of ROE for All Insured U.S.

Banks (1992-2007)

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-12

A Variation on ROE
Net Income
Pre-Tax Net Operating Income
ROE =

Pre-Tax Net Operating Income

Total Operating Revenue

Total Operating Revenue

Total Assets

Total Assets
Total Equity Capital

ROE = Tax Management Efficiency

Expense Control Efficiency
Asset Management Efficiency
Funds Management Efficiency
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2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-13

Breakdown of ROA

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2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-14

Quick Quiz
What individuals or groups are likely to be
interested in the banks level of profitability
and exposure to risk?
What are the principal components of ROE,
and what does each of the these components
measure?
Suppose a bank has an ROA of 0.80% and an
equity multiplier of 12x. What is its ROE?
Suppose this banks ROA falls to 0.60%. What
size equity multiplier must it have to hold its
ROE unchanged?
What are the most important components of
ROA and what aspects of a financial
institutions performance
do they reflect?
McGraw-Hill/Irwin
2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-15

Bank Risks
Credit Risk
Liquidity Risk
Market Risk
Interest Rate
Risk
Operational Risk

Legal and
Compliance Risk
Reputation Risk
Strategic Risk
Capital Risk

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-16

Credit Risk
The Probability that Some of the
Financial Firms Assets Will
Decline in Value and Perhaps
Become Worthless

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6-17

Credit Risk Measures

Nonperforming Loans/Total Loans

Net Charge-Offs/Total Loans
Provision for Loan Losses/Total Loans
Provision for Loan Losses/Equity Capital
Allowance for Loan Losses/Total Loans
Allowance for Loan Losses/Equity Capital
Nonperforming Loans/Equity Capital

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6-18

Liquidity Risk
Probability the Financial Firm Will
Not Have Sufficient Cash and
Borrowing Capacity to Meet
Deposit Withdrawals and Other
Cash Needs
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Bank Management and Financial Services, 7/e All Rights Reserved.

6-19

Liquidity Risk Measures

Purchased Funds/Total Assets
Net Loans/Total Assets
Cash and Due from Banks/Total
Assets
Cash and Government
Securities/Total Assets
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6-20

Market Risk: Comprises Price Risk

and Interest Rate Risk

Probability of the Market Value of the

Financial Firms Investment Portfolio
Declining in Value Due to a Change
in Interest Rates

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6-21

Market Risk Measures

Book-Value of Assets/ Market Value of
Assets
Book-Value of Equity/ Market Value of
Equity
Book-Value of Bonds/Market Value of
Bonds
Market Value of Preferred Stock and
Common Stock
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Bank Management and Financial Services, 7/e All Rights Reserved.

6-22

Interest Rate Risk

The Danger that Shifting Interest

Rates May Adversely Affect a
Banks Net Income, the Value of its
Assets or Equity
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Bank Management and Financial Services, 7/e All Rights Reserved.

6-23

Interest Rate Risk Measures

Interest Sensitive Assets/Interest
Sensitive Liabilities
Uninsured Deposits/Total Deposits

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6-24

Off-Balance-Sheet Risk
The Volatility in Income and Market Value
of Bank Equity that May Arise from
Unanticipated Losses due to OBS Activities
(activities that do not have a balance
sheet reporting impact until a transaction
is affected)

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6-25

Operational Risk
Uncertainty Regarding a Financial
Firms Earnings Due to Failures in
Computer Systems, Errors,
Misconduct by Employees, Floods,
Lightening Strikes and Similar Events
or Risk of Loss Due to Unexpected
Operating Expenses
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Bank Management and Financial Services, 7/e All Rights Reserved.

6-26

Legal and Compliance Risk

Risk of Earnings Resulting from Actions
Taken by the Legal System. This can
Include Unenforceable Contracts, Lawsuits
or Adverse Judgments. Compliance Risk
Includes Violations of Rules and
Regulations

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-27

Reputation Risk
This is Risk Due to Negative Publicity that
can Dissuade Customers from Using the
Services of the Financial Firm. It is the
Risk Associated with Public Opinion.

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-28

Capital Risk
Probability of the Value of the Banks
Assets Declining Below the Level of
its Total Liabilities. The Probability of
the Banks Long Run Survival

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-29

Capital Risk Measures

Stock Price/Earnings Per Share
Equity Capital/Total Assets
Purchased Funds/Total Liabilities
Equity Capital/Risk Assets

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Bank Management and Financial Services, 7/e All Rights Reserved.

6-30

Other Goals in Banking

Total Operating Expenses
Operating Efficiency Ratio =
Total Operating Revenues

Net Operating Income

Employee Productivity Ratio =
Number of Full Time-Equivalent Employees

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2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.

6-31

Performance Indicators Related to

the Size of a Firm, 2007

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6-32

Appendix: UBPR
The Uniform Bank Performance
Report Provided by U.S. Federal
Regulators so that Analysts Can
Compare the Performance of One
Bank Against Another
Web link for UBPR and BHCPR:
www.ffiec.gov
McGraw-Hill/Irwin
2008 The McGraw-Hill Companies, Inc.,
Bank Management and Financial Services, 7/e All Rights Reserved.